Austerity under attack

Europe seems to be obsessed with austerity. Country after country is being forced by either the financial markets or the European Union to start cutting its public-sector deficit. And, as if this were not enough, 25 of the 27 EU member states have just agreed on a new treaty (called a ‘fiscal compact’) that would oblige them never to have a cyclically adjusted budget deficit of more than 0.5% of gross domestic product (GDP). (For comparison, the United States’ budget deficit in 2011 was close to 8% of GDP.)

But, as the European economy risks falling into recession, many observers are asking whether ‘austerity’ could be self-defeating. Could a reduction in government expenditure (or an increase in taxes) lead to such a sharp decline in economic activity that revenues fall and the fiscal position actually deteriorates further?

This is highly unlikely, given the way our economies work. Moreover, if it were true, it would follow that tax cuts would reduce budget deficits, because faster economic growth would generate higher revenues, even at lower tax rates. This proposition has been tested several times in the US, where tax cuts were invariably followed by higher deficits.

In Europe, the concern today is instead with the debt/GDP ratio. The worry here is that the GDP drop resulting from ‘austerity’ might be so large that the debt ratio increases. This matters, because investors often use the debt ratio as an indicator of financial sustainability. Thus, a lower deficit might actually heighten tensions in financial markets.

However, a lower deficit must lead over time to a lower debt ratio, even if this ratio worsens in the short run. After all, most models used to assess the economic impact of fiscal policy imply that a cut in expenditure, for example, lowers demand in the short run, but that the economy recovers after a while to its previous level. So, in the long run, fiscal policy has no lasting impact (or only a very small one) on output. This implies that whatever short-run negative impact lower demand may have on the debt ratio should be offset later (in the medium to long run) by the rebound in demand that brings the economy back to its previous output level.

One-off phenomenon

Moreover, even assuming that the impact of a permanent cut in public expenditure on demand and output is also permanent, the GDP reduction remains a one-off phenomenon, whereas the lower deficit continues to have a positive impact on the debt level year after year.

Notice that this conclusion was reached without any recourse to what Paul Krugman and others have derided as the “confidence fairy”. In the US, it might indeed be unreasonable to expect that a lower deficit translates into a lower risk premium – for the simple reason that the US government pays already ultra-low interest rates.

But, even without any confidence effects, the bipartisan Congressional Budget Office has concluded that, while cutting the US deficit does lower demand, it still leads reliably to a lower debt ratio. This should be all the more true for eurozone countries, such as Italy or Spain, that are now paying risk premia in excess of 3%-4%. For these countries, the confidence fairy has become a monster.

The decisive question then becomes: what matters more, the impact of deficit cutting on the debt/GDP ratio in the short run or in the long run?

Prospective buyers of Italian ten-year bonds should look at the longer-term impact of deficit cutting on the debt level, which is pretty certain to be positive. Of course, some market participants might not be rational, demanding a higher risk premium following a short-term deterioration of the debt ratio. But those who concentrate on the short term risk losing money, because the risk premium will eventually decline when the debt ratio turns around.

Abandoning austerity out of fear that financial markets might be short-sighted would only postpone the day of reckoning, because debt ratios would increase in the long run. Moreover, it is highly unlikely that Italy, for example, would pay a lower risk premium if it ran larger deficits.

It would be dangerous for the eurozone’s highly indebted countries to abandon austerity now. Any country that enters a period of heightened risk aversion with a large debt overhang faces only bad choices. Implementing credible austerity plans constitutes the lesser evil, even if this aggravates the cyclical downturn in the short run.